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Strategy Analysis – Options
Long Call
Action: Buying a Call option
Expectation: Stock/Market will be Bullish
Profit: Unlimited on stock price/market rising
Loss: Limited to amount invested into position (premium)
Breakeven: Strike price + premium
Index
Long Call ...................................................................................................................................................... 1
Explanation ................................................................................................................................................... 2
Benefits......................................................................................................................................................... 2
Risks ............................................................................................................................................................. 2
How to … ..................................................................................................................................................... 3
Tips & Hints.................................................................................................................................................. 3
Payoff Diagram – Long Call.......................................................................................................................... 4
Call Strike Prices ATM/ITM/OTM ............................................................................................................. 5
Volatility – Long Call.................................................................................................................................... 6
Greeks........................................................................................................................................................... 6
Trading Plan.................................................................................................................................................. 7
Resources...................................................................................................................................................... 8
Disclaimer..................................................................................................................................................... 9
© Copyright FMRAnalysts, 2007. All rights reserved.
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Explanation
Option traders use Call option contracts to benefit in a rise in the underlying share price. Options trade at a
discounted price to the share. Therefore, instead of outlaying the full value for the shares, you can benefit in a
rise in price with less exposure of capital.
Example:
QQQQ QQQQ Dec 51.00 Calls
Price $51.07 $2.33
Number 100 shares 1 contract
Total Value $5,107.00 $233.00
To purchase 1 QQQQ Dec 51.00 call, we would spend $233.00 (not including brokerage). The equivalent value
of shares is $5,107, giving us “leverage” over a rise in the share price.
Benefits
· Using the same principles for decisionmaking for investment with stocks
· Purchasing longterm options requires a smaller investment to hold value of the same underlying stock
position. Example; $10,000 of stock might be approximately $1,000 of option value. Gives you leverage
exposure over the stock.
· Risking smaller amount of investment capital to gain a larger percentage of profit.
· Can Buy an option that benefits from the markets increasing.
· Can also adopt defensive strategies if the markets change conditions.
· Gives you time to decide whether or not to purchase the underlying shares, but still benefitting from any
potential gainin value.
Risks
· Lack of understanding can cause investors to pay too high a price for options or to purchase wrong
options to suit expected goals.
· Education and practice are required to gain a thorough understanding of options. This takes time and
patience.
· 100% of position could be lost if position is not managed correctly
· Different strategies could be adopted depending on the investors outlook for the stock and timeframe
for investment
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How to …
· Establish that share price is likely to rise
· Decide on time frame for expected move in value
· Choose the type of Call option you wish to purchase – ATM/OTM/ITM. This includes what strike price
and expiration.
· Establish exit criteria before entering into position. How long will you hold the position if it is shifting
against you? At what point will you close the position for a profit?
· Place order for selected Call option
Tips & Hints
· Only purchase options if you fully understand how they work, and have practiced and evaluated your
results
· Longterm (long expiration date) options can be purchased, and strike prices on different levels.
Different options will suit different outlooks for time.
· As with any investment strategy, only invest capital that you can afford to invest with.
· An understanding of Volatility, the Greeks and Theoretical values will help establish which option
contract to trade.
· Establish a clear and precise plan for entry and exit.
· Although you use less capital on the one position, do not increase the amount of money you use.
Example, you may buy $10,000 of stock, but do not buy $10,000 of options. Purchase $1,000 of options
or 10% of the value you would use on stocks (this is an example)
© Copyright FMRAnalysts, 2007. All rights reserved.
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Payoff Diagram – Long Call
Payoff Diagrams show the potential profit or loss for a position, when the underlying share price is trading at
different prices. It will also highlight the breakeven level for the trade.
A payoff diagram assumes the position is at expiry, showing only the intrinsic value of the option.
Total Profit/Loss
4
3
2
Profit/Loss
1
0
47.00 48.00 49.00 50.00 51.00 52.00 53.00 54.00 55.00 56.00 57.00
1
2
3
Stock Price at Expiry
The Payoff Diagram for a Long Call option position shows the following information:
· Breakeven: Exercise price ($51.00) plus Premium paid ($2.33) = $53.33. That is, if QQQQ is trading
above $53.33, than this position will be in a profit
· Maximum Loss: $2.33
· Maximum Profit: unlimited
· Time: on or before expiration of the December contracts
Rising Share Price
As QQQQ rises in value, the payoff diagram shows us that the value of the QQQQ Dec 51.00 calls will rise as
well.
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Call Strike Prices ATM/ITM/OTM
ATM: At The Money
This refers to the strike price that is At (or Near) the current share price. ATM strike prices have little to no
Intrinsic value. Offers the best balance between the risks and rewards for the strategy.
OTM: Out of The Money
This refers to the strike prices that are above the current share price. OTM Call options will produce a
significant return if the share price rises strongly, but also has greater risk of losing value should the share price
remain steady or fall.
ITM: In The Money
This refers to the strike prices that are below the current share price. ITM Call options have the lowest
breakeven levels but also have the highest premium cost (due to the Intrinsic Value). Profit, although leveraged,
is not as strong as the OTM Call option, however, the risk is also lower
Example:
QQQQ currently at
$51.07
Call Strike Put
Options Price Options
46.00
47.00
ITM 48.00 OTM
49.00
50.00
ATM 51.00 ATM
52.00
53.00
OTM 54.00 ITM
55.00
56.00
© Copyright FMRAnalysts, 2007. All rights reserved.
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Volatility – Long Call
· Volatility refers to the degree of unpredictable change over time of a certain variable.
· Historical volatility is the volatility of a financial instrument based on historical returns, while Implied
Volatility is the volatility that, given a particular pricing model, yields a theoretical value for the option
equal to the current market price.
· The more volatile a stock, the greater the time value is likely to be, due to the increased uncertainty of
where the share price might be in the future.
· Long Call option takers (buyers) should look for low Volatility on the position they are evaluating.
Greeks
Delta: positive, ranging between 0 and 1. OTM calls are closer to 0, ATM calls are around 0.5, and ITM calls
are closer to 1. Delta increases towards 1 as the underlying rises and the call moves further/closer ITM.
Gamma: positive. It is highest around the ATM option, especially as the option approaches expiration.
Theta: negative, as the option contract will lose time decay each day. The closer the number to 0, the better.
The value of the position will decrease as the option loses time value.
Vega: an increase in Vega should find an increase in the options’ change in value. Vega varies depending on
whether it is an OTM/ATM/ITM option, as well as when time to expiry decreases. The value of the position
will tend to rise if implied volatility increases. Vega will be highest the closer the underlying is to the strike
price, and the longer the time to maturity.
© Copyright FMRAnalysts, 2007. All rights reserved.
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Trading Plan
To use the Long Call strategy, you need to have a Plan. For a higher probability of profiting from this strategy,
FMR Analysts recommends you practice, or Paper Trade, before you begin using real capital in the markets.
1) Make a decision that you expect the underlying (market/stock) is going to rise in value
2) Outline how much you expect the underlying might gain
3) Choose a timeframe in which you expect this will occur
4) Evaluate the option to see if it meets the criteria you want
5) Establish your entry and exit rules
6) Enter position
There are a number of points you should consider before entering this strategy. FMR Analysts have outlined
some of the questions you should consider:
© Copyright FMRAnalysts, 2007. All rights reserved.
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Resources
The information contained in this article portrays all the basic information you require to understand options.
However, your understanding may not yet be completely clear.
Most of the information you will need to completely understand options is available for free on the internet.
FMR Analysts has researched the best resources for you to complete your learning of options.
Chicago Board Options Exchange – Learning Centre
Go straight to the exchange to learn about options. At the CBOE online Options Institute, you can:
· View selfguided online tutorials
· Conduct selfpaced interactive online courses
· Watch live interactive educational webcasts, or
· Book to attend a live seminar.
http://www.cboe.com/LearnCenter/default.aspx
Books
There are many books written on options, and how to understand them. The following are selections FMR
Analysts recommends for the beginner:
Options for Equity Investors
Author: Wendy Newton
The Secrets of Writing of Options
Author: Louise Bedford
Options: A complete guide for Australian investors and traders
Author: Guy Bower
FMR Bookstore: http://fmranalysts.blogspot.com/2006/09/bookstore.html
© Copyright FMRAnalysts, 2007. All rights reserved.
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Disclaimer
Trading involves risk of loss and may not be suitable for you. Past performance is no guarantee or reliable indication of future
results. This advertisement is of the nature of general information only and must not in any way be construed or relied upon as
legal, financial or professional advice. No consideration has been given or will be given to the individual investment objectives,
financial situation or needs of any particular person. The decision to invest or trade and the method selected is a personal
decision and involves an inherent level of risk, and you must undertake your own investigations and obtain your own advice
regarding the suitability of this product for your circumstances. Please ensure you obtain and read the current offer
documentation prior to acquiring the products advertised herein, so you are fully informed regarding the key risks and costs
associated with these products.
© Copyright FMRAnalysts, 2007. All rights reserved.